"Do stock markets serve investors?
In the wake of the current crisis, the British government invited LSE Prof John Kay to review the UK equity market and its impact on the governance of UK-listed companies. The report was published on July 23 and has many lessons on the theory and practice of Asian stock markets.
Stock markets play an important role in the economy, by enabling listed companies to raise capital, improve the price discovery of shares, help in risk management at the corporate and national level and also exercise discipline on the corporate governance and performance of listed companies. The series of crises in stock markets in Asia (1997-99), the tech bubble (2000) and the current crisis (2007-2011) all questioned whether stock markets perform well in practice.
Kay's study suggested that short-termism is a fundamental problem in UK equity markets and that the principal reasons are a decline in trust and the misalignment of incentives throughout the equity investment chain. These underlying trends are reflected in facts about the UK equity market. British companies are investing less in the real economy, their investments falling from over 13% of GDP to less than 10% of GDP and their R&D is the lowest compared with the United States, Germany and France.
In fact, new net equity issuance by British-listed companies has been negative in the last decade, with IPO new capital offset by share buybacks and acquisition of listed companies by cash. This is not only because listing costs are high, but also because the total return on listed shares have been disappointing the FTSE all-share index returned 4.5% per annum in the last decade.
The author suggests that 4.5% per annum is a disappointing result for long term investors in British equities. I am afraid that 4.5% was a very decent result, almost the best one could wish for in the last 15 years or so. Here is the 50-year graph of the FTSE All shares index:
The return of 4.5% is based on 2002 where the FTSE was below 2000 points and its current value of about 3000.
In contrast, people who would have started investing in 1999/2000 or 2007/2008 would have negative returns.
To calculate the real returns:
- plus: dividends, a few percent a year, probably 3% per year
- minus: expenses, probably 1% per year
- minus: inflation, severely underreported by most countries in the world (Malaysia is not an exception), my guess for the UK is about 5% per year
One basic thrust of the Kay Report is that all participants in the equity investment chain should act according to the principle of stewardship, which is founded on trust. Hence, the report recommends that regulatory practice should favour investing over trading, not the other way round. In other words, the regulatory framework should enable and encourage companies, savers and intermediaries to adopt investment approaches that achieve long-term value.
In this current world of short-termism, this is easier said than done, since many financial intermediaries, especially investment banks, make more money from short-term trading than from long-term investing. What is very interesting is that the Kay Report felt strongly enough on short-termism to recommend that mandatory quarterly reporting obligations be removed. This is music to the ears of corporate captains who feel that they should be focused on building long-term value, rather than worrying about how the next quarterly report would depress stock prices.
The Kay Report is very much welcome as a fundamental review of how stock markets should perform their important function of helping the real economy grow and create jobs for the long term. These are important lessons for Asian stock markets, investors and financial regulators.
Some general comments about the Kay report can be found here, the report (111 pages) itself here, a review by The Guardian here.
Food for thought for the Malaysian authorities, although I strongly recommend to skip the paragraph about stopping the requirement for quarterly reporting. The fact that some people misinterpret quarterly reporting is no reason not to publish them.